Economic Stress and the Middle Class, Part II

A US family must receive an income today in the top 20% to enjoy the benefits of a typical Middle Class family of the 1970s.

Although incomes have increased many times since then, real wages peaked in 1972 and have remained flat ever since. Put another way: Incomes may have risen, but buying power of the money received has decreased and erased any gain.

William Baumol, an economics professor at Princeton, predicted that the costs of goods would fall over time, but the costs of healthcare and education would rise and require a larger and larger share of national as well as personal income. This has proven to be the case.

Since real incomes have remained flat while expenses have increased, the amount left over has shrunk and it is this shrinkage that has caused many families that were solidly Middle Class in the past to go without.

Although the largest expense increases may have been in medical and educational costs, they do not account for the entire rise in expenses. There is another significant factor at work and for this to be appreciated it is necessary to know several things about interest rates.

An interest rate is the amount of money paid by the borrower to a lender for the use of a sum of money. It is expressed as a percentage.

In spite of this innocent definition, the subject has probably been the foundation of more controversy, the source of more wealth, and the cause of more ruin than any other single concept in human history other than conquest through force of arms.

Their history is not taught in schools yet interest rates are a fundamental that underpins the majority of what is called Economics.

The subject was considered so pernicious by the medieval Christian church, that charging any interest on a loan was considered a crime and this was the case for over a thousand years.

Charging interest is not a modern invention. Ancient civilizations in Greece, India, China, Japan, and South America all charged interest for loans, but it was not until Hammurabi, the sixth king of Babylon (ca. 1750 BC), that the first known attempt to regulate interest rates came about. He put a ceiling on loans for grain at 33.3% and 20% for loans for silver.

Under his rule all loans had to be in writing and witnessed by a public official. Over-charging on interest meant the loan was cancelled. The use of collateral was standard even in the form of wives, children, and slaves when hard assets were few. But the law forbade slavery due to debt for more than three years.

Hammurabi’s rules on lending remained mostly unchanged for 1,200 years and may be considered enlightened when compared to later practices.1

How interest rates were determined during those times is not known.

We do know that for interest rates to be regulated and set below a certain percentage, they must have risen much higher before the regulations came about. Further these laws came into existence to protect the borrower rather than the lender because lenders rarely had an urgency to lend while borrowers were often driven by overwhelming need to borrow at any cost.

It is likely that risk of loss was a key factor in determining the rate of interest charged but in larger economies competition for the use of capital may have driven rates up as well.

We also know (see article, The Spice Trade) that the possible return on investment in the case of overseas trade during the 15th through the 17th centuries was high even by today’s standards making it worthwhile to risk the heavy burdens (imprisonment and torture) that were placed on those who failed to make timely payments.

By the 16th century, the charging of interest was widespread again as the power of the Catholic Church waned and trade increased between nations. But their abuse did not disappear.

Even today it has been necessary to regulate the maximum interest that can be charged.

In the United States under the RICO statutes (Racketeer Influenced and Corrupt Organizations Act), it is unlawful to lend money at a rate more than twice the local state usury rate. In the US, usury laws (laws that prohibit excessive interest) are state laws, and it is the states that set the maximum legal interest.2

Today these range from 8% in Alabama, to a maximum in the State of Florida of 25% for amounts over $500,000. 3

Rates in the last eighty years have been set by markets with the exception of the last six years where the Federal Reserve and other central banks have skewed them significantly lower to “promote economic growth”.

Prior to this, an off-the-cuff rule to determine what would be a typical interest rate on a loan was to start with the risk-free rate of return.

The risk-free rate was the rate of return that a person would lend another where there was little or no chance of default. Historically 3% has been the accepted amount. In more recent times this figure has been replaced by the rate of interest on a one year US Treasury which fluctuates on a daily basis and is quite a bit lower.

The likely interest of the loan is determined by adding to the rate of inflation the risk-free rate. To this amount is added a percentage for the term of the loan, and an additional amount to account for the likelihood of a default. The result is what interest rate should be charged.

The largest variable is the inflation rate.

The rate of inflation has varied widely. Today according to some measures it is around 2%.

In 1980 inflation in the US hit an annual rate of almost 15%.

Using the interest formula above in 1980 would mean that a simple no-risk loan would cost about 18%.

One year certificates of deposit paid this amount at that time.

Banks want deposits.

A depositor is a lender to a bank. In today’s world this concept is often overlooked but it is true nonetheless. You are not simply a customer or an account number.

Banks make money by lending out more than their deposits. The current ratio is around 10 to 1. This is called “fractional banking”. Banks try to lend out ten times the amount of deposits they have on hand.

This element is important for the next part of the story.

By the 1980s many banks, particularly Savings and Loans, were in trouble. For the last thirty years they had been lending money at a rate of 6% in the form of mortgages based on one-tenth the amount of deposits. As interest rates rose due to inflation they had to pay depositors three times as much to keep their banks afloat.

With fractional banking there is no waiting for people to pay off their loans. A bank needs deposits to satisfy regulators that require they have on hand 10% of all loans in cash or equivalents. If a bank is not competitive on the interest it gives depositors, depositors will be lured to institutions that are, and deposits will leave creating the situation of lots of loans and no cash.

This tension between low income from existing loans made in the past and present high expenses generated by demands for interest by depositors was at the heart of the Savings and Loan Crisis of the 1980s.

The results of this crisis besides a major banking disaster were two changes that altered the financial landscape forever:

The first was the start of a trend that has continued unabated ever since called “Financialization”.

Financialization describes an economic system that puts a value on all assets whether tangible or intangible so they can be made into a financial instrument and traded. An example is to package many mortgages together and sell them in $1,000 certificates called “Collateralized Mortgage Obligations”.4

The thinking at the time was that if the Savings and Loans companies had been able to sell their mortgages to raise cash, a disaster could have been prevented. Many banks had been stuck with loans earning 6% in an environment where a loan should earn 25%, and it strangled them. They loaned at 6% and paid out at 25%.

Creating financial instruments and markets in which to trade them became a high priority for banks and financial institutions.

The second change was that banks became able to invest in anything they chose.

The thinking here was that if those troubled banks had been able to invest in any financial instrument they wanted to, they too could have invested and earned the same high rates of return from money market accounts that investment companies and mutual fund companies did.

A bank that held deposits could not invest in the higher risk instruments that investment and mutual fund companies did. These financial institutions lured millions of dollars away from banks by delivering much higher rates of return.

After the 1929 crash, restrictions as to kinds of investments were made into laws to prevent banks from taking on too much risk.5

After the Savings and Loan Crisis, banks lobbied and won the repeal of these regulations.

Today commercial, savings, and investment banks are on an equal playing field so that no one type of bank had an advantage over another.

It is indeed ironic that the two solutions: Financialization and lower barriers to investment were what ultimately led to the next banking crisis in 2008.

But before this new banking crisis could unfold, banks had to have made a great deal more money and that was done in a subtle and effective way.

How that was carried out, and what that meant to the Middle Class will be covered in Part III of this series.